On personal finance.

Most Intelligent Risk Is A Portfolio That's Diversified

When it comes to your investments, a better approach may be to have investments in several asset classes that move at different times. In other words, when one investment is up, another is down.

If you are properly diversified, you are almost certain to have at least one loser in your portfolio, says Judith Martindale, a top-ranked financial planner from San Luis Obispo, Calif.

Oddly enough, many experts say that's good, because it reduces your portfolio's volatility. And you have more money in your pocket at the end of the day when you earn a stable 10 percent return than when you earn a volatile 10 percent average return.

How so? Consider two hypothetical investors. Ray Risk puts all his money in a volatile sector fund, which invests all its money in one industry. Because this industry goes through good years and bad, this sector fund gains 30 percent one year, loses 10 percent the next. Sure, that lands you a 10 percent average return, but your performance chart looks like a heart monitor.

The other investor, Sue Stability, puts her money in an asset allocation fund that invests in a mix of stocks and bonds. The fund never beats the market--but it manages to click out 10 percent returns year after year.

They both invest $10,000. But, at the end of 10 years, Sue has considerably more. In years that Ray lost money, Sue made money; the following year, she made money on a larger amount of money, while Ray earned a higher return on a diminished stockpile.

Of course, most investors who take the sector approach, aiming to invest their assets in only the industry group or groups that are doing the best at the time, understand that their returns are going to be volatile. But they also believe they'll earn much higher returns overall, along with taking on more risk.

Risk, in the financial markets, is largely measured through "standard deviation," which is a fancy term for volatility. The more a stock price or a market index deviates from a set point--up or down--the more risky the investment is considered.

Taking intelligent risks generally increases your chances of reaping bigger returns. For example, big-company stocks are far more volatile than Treasury notes, so you should expect to earn much higher average annual returns over time. And, in fact, you have. Where Treasury notes have yielded a 5.2 percent compounded average annual return from 1925 to the present, large-company stocks have returned 11.4 percent. Small stocks are more volatile than large stocks, so again, you expect--and get--a higher average rate of return--12.6 percent, historically.

But what is true over entire asset classes is not necessarily true for individual stocks or industries. Consider, for example, people invested in the "new paradigm" stocks of yesteryear. RCA Corp. was state-of-the-art, bringing the newfangled technology--radio--to the masses in the 1930s, notes Bill Berg, president of Sigma Investment Management Co. in Portland, Ore. During that period, the number of radios tripled, but someone who bought RCA at its peak in 1929 didn't break even on their investment until 1965, Berg said.

The hot technology in the early 1980s was personal computers, which pundits rightly predicted would change the world, he adds. But the hot computer stocks--indeed, the bulk of the publicly owned computer manufacturers--of the early 1980s don't even exist today. Remember Kaypro, Osborne and Eagle?

"Academic theory says that intelligently assumed risk is rewarded. But in the financial markets, an intelligent risk starts with a diversified portfolio," Berg says. "When you start focusing on individual companies or individual industries, that is risk that is not necessarily rewarded."

To see why the stability of your portfolio matters, consider the returns of our two hypothetical investors, Ray Risk and Sue Stability.

They each earn an average of 10 percent, but the stable portfolio returns 10 percent each year; the risky portfolio is up 30 percent one year, down 10 percent the next. If they both invest $10,000 for 10 years, the risky investor's net portfolio value is $21,923, while the stable investor's net portfolio value is $25,937.